Volume 23, No. 8

A Better Way to Evaluate Executive Pay: The investing world holds conflicting views on executive compensation, when the subject is considered at all. Executive pay doesn’t explicitly enter into the calculation of earnings per share, whether it’s an original recipe (GAAP), or extra-spicy (non-GAAP), so investors don’t always spend a lot of their analytical firepower on how much they get back from executives for their pay. If institutional investors think about executive compensation at all, it’s usually once a year when their proxy advisers suggest a thumbs-up-or-down on pay plans. There’s the occasional “say on pay” where dissatisfaction with pay is registered, but those are rare - and toothless.

The pay levels are truly staggering - $14.5 billion among a cadre of 2,547 managers in 469 S&P 500 firms. That’s a slight drop from 2012, but they’re still enormous. At least superficially, the decline might seem like good news. Yet it doesn’t say anything about whether shareholders received value for the pay given to their firms’ managers.

It’s easy for investors to feel uneasy about pay levels: they generally keep climbing, and equity markets don’t always do the same. Yet investors don’t usually seem to care much about executive pay as long as earnings (of some sort) increase – and that’s a slovenly habit. Managers are paid to allocate capital – to make decisions about how to reinvest the cash and profits generated by the investor’s business. Investors should make a comparison between the success of managers in generating incremental returns on capital and their incremental pay changes – and that might make them look more critically at pay packages.